RSI and ATR Explained: Momentum and Volatility Indicators for Stocks

The Relative Strength Index (RSI) measures how strong a stock's recent gains have been compared with its recent losses, on a scale from 0 to 100, and readings above 70 are often called overbought and below 30 oversold. The Average True Range (ATR) measures how far a stock typically moves in a day, in dollars. RSI helps you judge momentum and stretched moves, and ATR helps you set stop-losses and position sizes that suit each stock's volatility.

Both indicators were introduced by J. Welles Wilder Jr. in his 1978 book New Concepts in Technical Trading Systems, and both are built into almost every charting platform.

The Relative Strength Index (RSI)

The standard RSI uses 14 periods (14 days on a daily chart):

1. Work out the average gain on up days and the average loss on down days over the last 14 periods (Wilder used a smoothed average).
2. RS = average gain / average loss.
3. RSI = 100 - 100 / (1 + RS).

What RSI levels really mean

• Above 70: recent gains have been much bigger than losses. In a range, that often means the stock is stretched. In a strong uptrend, RSI can stay above 70 for weeks while the price keeps rising.
• Below 30: recent losses have dominated. In a downtrend, RSI can stay low while the price keeps falling.
• Around 40-50: in healthy uptrends, pullbacks often stop with RSI in this zone; in downtrends, rallies often stall near 50-60.

Three ways traders use RSI

1. As trend context. An RSI that keeps holding above 40 on pullbacks supports an uptrend.
2. For pullback entries. In a stock above its rising 200-day average (see moving averages), a dip that pushes RSI towards 30-40 can offer a lower-risk entry than chasing a breakout.
3. For divergence. If the price makes a higher high but RSI makes a lower high, momentum is fading. Divergence is a warning to tighten stops, not a sell signal by itself; it can last a long time.

The Average True Range (ATR)

ATR starts from the true range of each day, the largest of:

• today's high minus today's low;
• the gap between today's high and yesterday's close;
• the gap between yesterday's close and today's low.

Using yesterday's close means overnight gaps count, which matters a lot for stocks.

The ATR is the average true range over a period, usually 14 days. It is in dollars, so to compare stocks, divide by the price:

Stock	Price	ATR (14)	ATR as % of price
A	$200	$4.00	2.0%
B	$50	$2.50	5.0%

Stock B is more than twice as volatile as Stock A, even though its ATR in dollars is smaller.

Using ATR to set stops

A fixed-percentage stop, such as 5% below entry, is too tight for a volatile stock (normal noise will hit it) and too loose for a calm one. An ATR stop places the stop a multiple of ATR away, often 2 to 3 times:

• Stock A: 2.5 x $4.00 = $10 below a $200 entry, so the stop is at $190.
• Stock B: 2.5 x $2.50 = $6.25 below a $50 entry, so the stop is at $43.75.

A trailing ATR stop (sometimes called a chandelier stop) sits a multiple of ATR below the highest close since entry and only moves up. For example, 3 x ATR under the highest close.

Using ATR to size positions

Combine the ATR stop with a fixed dollar risk per trade, covered in depth in position sizing and stop-losses.

Putting them together

A simple, testable swing setup that uses both:

1. Trend: the stock closes above its rising 200-day moving average.
2. Entry: RSI(14) dips below 40, then closes back above it; buy at the next open.
3. Stop: 2.5 x ATR(14) below the entry price.
4. Exit: a trailing stop of 3 x ATR under the highest close, or a close below the 200-day average.
5. Size: risk 1% of the account per trade.

This is an example to learn from, not a recommendation. Before trading anything like it, test it over many stocks and years, with costs, as shown in backtesting stock strategies. Some of the rules on the DanioX stocks backtest use ATR-based stops in exactly this way, and the page lists each rule's stop.

Next: how these tools combine into full strategies, in stock trading strategies.